Market Mechanisms to Tackle Climate Change: Europe is Getting Ready for the Use of Post-Kyoto Emissions Trading

Jos Cozijnsen, L1.
Consulting Attorney
Utrecht, The Netherlands

Overview
With climate change negotiators meeting at The Hague in November 2000, it is timely to consider recent European developments in connection with the Kyoto Protocol, which calls for marked reductions in emissions of six key greenhouse gases ("GHGs") – carbon dioxide, methane, nitrous oxide, hydrofluorocarbons, perfluorocarbons, and sulfur hexaflouride – during the period 2008-2012. The European Union ("EU") as a whole will have to reduce anthropogenic emissions of these gases by 8% from 1990 levels, while Japan and the U.S. will have to reduce their emissions by 7% and 6%, respectively. The Kyoto Protocol identifies three mechanisms ("Kyoto Mechanisms") that can be used for this purpose: (i) international emissions trading ("IET"), which would involve "cap-and-trade" in Assigned Amount Units ("AAUs") GHG emissions between sovereigns; (ii) joint

implementation ("JI"), which would involve the financing of GHG emission reduction projects by an industrialized country in another industrialized country (having a cap on emissions); and (iii) the clean development mechanism ("CDM"), through which investments by developed countries in projects in developing countries that reduce emissions below what would have otherwise occurred may generate Certified Emissions Reduction units ("CERs").

This article examines ongoing and planned national and regional pilot schemes for GHG emissions trading in Europe. The objective of the discussion is to identify the building blocks of the domestic and regional domestic emissions trading schemes, and to assess the consistency and coordination leading to international emissions trading in the framework of the Kyoto Protocol. The article concludes that emissions trading developments in Europe are numerous and will likely lead to real "cap-and-trade" schemes. Domestic schemes are tailor-made and tend to meet national political considerations and circumstances. Cross-border trading arrangements could be facilitated by international frameworks that foster cooperation in the elaboration of compatible schemes and the development of international arrangements in the framework of the Kyoto Protocol.

Ensuring an Effective and Workable Emissions Trading Scheme
At least two prerequisites must be satisfied if there is to be an effective and workable emissions trading system. First, there must be environmental credibility, in the sense that the system yields actual reductions in overall GHG emissions. Second, there must be a means of ensuring compliance, including legal standards and rules for accountability and domestic enforcement. See Environmental Defense, Cooperative Mechanisms under the Kyoto Protocol: The Path Forward (June 1998) (Identifying the following elements of an effective and workable emissions trading system: measurement, transparency, fungibility, accountability and consistency), available at <http: www.environmentaldefense.org>. See also Market Mechanisms & Global Climate Change: An Analysis of Policy Instruments (Pew Center on Global Climate Change 1998), available at <www.pewclimate.org>. These two prerequisites are explored below in the context of various emissions trading initiatives.

Denmark
On May 29, 2000, the European Commission approved the planned Danish carbon dioxide quota system for the electricity sector. Under this system, the state will allocate emissions permits to electricity producers based on average historical emissions for the period of 2001-2003. New entrants will be allocated permits based on objective, non-discriminatory criteria. For that purpose, part of every year’s quota is withheld. The European Commission has indicated that it considers allocation based on historical usage as State Aid under Art 87(1) of the EC Treaty. The Commission further finds that it can approve the State Aid on the basis of Article 87(3)(c), since it will contribute to development of environmental protection. The Commission underlines the freedom of establishment, although new entrants are not easily expected due to the current 150% over energy capacity in Denmark. The scheme is part of a regulatory reform agreement for the energy sector to implement the EU directives on liberalization of the markets for electricity and gas.

The overall ceiling for the participants is established at 22 million tons of carbon dioxide in 2001, 21 million tons in 2002, and 20 million tons in 2003. Emissions in 1997 amounted to 28.9 million tons. The quota for each producer will be adjusted, taking into account the national quota, transactions made and permits saved. The partial ceiling leads then to a reduction of actual emissions of the electricity sector with 70% compared to 1997. The fine for exceeding the quota is DKK 40/tons (around US$5/tons). Excess permits can be sold to another producer, for whom it is cheaper to buy a permit than to buy the fine. Whether the fine must be paid will also depend on the price of electricity. Denmark hopes this scheme will invite other Member States to join comparable arrangements and to set up trading schemes with other states.

This is the first European emissions trading scheme. The goal of the quota is to secure cost-effective carbon dioxide emission reduction and, furthermore, to prepare for the use of the Kyoto Mechanisms. It is also clear that it was developed to win some experience and to prepare a larger, European scheme. Hence, the system doesn’t mean a real "cap-and-trade" arrangement, because there are a limited number of players, with comparable marginal costs. Moreover, the fine is small and more closely resembles a tax. Producers cannot buy permits or reductions from other sectors nor from abroad. The low penalty system also accounts for the risk that an economically rational emitter operating in the system will continue to emit, and pay the penalty of DKK40/ton in the future. Missing is the use of public registries. The trade is seen as a bilateral scheme between companies and government, with a dominant role for the government and a minor one for the NGO community.

United Kingdom
In March 1999, the United Kingdom announced a plan to introduce a Climate Change Levy ("CCL") by April 1, 2001. The plan will tax electricity at a rate of UK0.6 pence/kWh, and coal and gas at UK0.21pence/kWh, to be levied on industrial customers. Certain industrial sectors would be allowed a significantly lower tax rate in exchange for undertaking agreements between those sectors and the Government to improve their energy efficiency, including the use of carbon trading. Sectors eligible for such treatment include steel, aluminum, chemicals, paper, ceramics, food and drink, glass, cement, and foundries. Such agreements should detail: (i) the installations covered; (ii) the savings target; and (iii) arrangements for monitoring, reporting and auditing. Trading will be allowed within and between sectors. Businesses within a sector, along with their trade association, will decide how to allocate the negotiated sector target between them.

In response to the Government’s CCL proposal, the Confederation of British Industry ("CBI") and the Advisory Committee on Business and the Environment ("ACBE") launched an initiative to design an industry-wide pilot emissions trading scheme, which could be linked into a future international emissions trading system. They launched the Emissions Trading Group ("ETG") in June 1999, involving representatives from some 40 firms and trade associations. The ETG council is comprised of board-level representatives from all the businesses involved plus environment, trade and treasury Ministers. Under the ETG proposal: (i) businesses that agree to an annual greenhouse gas emissions limit will receive permits to match that limit; (ii) businesses with pre-existing Climate Change Levy agreements based on energy efficiency per unit of output (rather than on an absolute level of GHG emissions) would not receive permits, but would be permitted to participate in trading; (iii) businesses investing in projects to reduce GHG emissions would receive credits, that could be sold in the market; and (iv) permits not needed to meet a business’ target could be banked for use in future years – however, the amount of banked permits that could be used during the Kyoto commitment period of 2008-2012 would be restricted.

The Government confirmed its support for the ETG’s proposals in March 2000, stating: "…the Government believes that emissions trading has a key role to play in reducing greenhouse gas emissions. The Government is keen to have an operational scheme up and running as soon as possible." The Government has backed such statements with promises to fund incentives for companies to cap carbon dioxide emissions at an amount requested by the ETG. While it is not yet clear how the system will work, it is likely to take the form of an auction in which companies will bid for funding in return for promised cuts in emissions. Once the caps have been set, companies that succeed in making more than their agreed cuts will be able to sell the surplus to companies that find it more difficult or expensive to make cuts. Critical to the success of the initiative will be liquidity and the number of participants. The program appears to be broad with large coverage and fungibility, but details are lacking, and questions persist about the linkage with the domestic carbon dioxide emissions reduction target.

Norway
A Norwegian Parliamentary Commission has recently completed a report outlining a system for domestic emissions trading in greenhouse gases. See <http: www.odin.dep.no>. The Commission recommends a system that would cover as many sectors and sources as possible, and suggests that those included would have to surrender quotas to the authorities starting in 2008. The Commission could not reach agreement on the question whether some sources should be grandfathered. The system would apply to all greenhouse gases listed in the Kyoto Protocol and would cover approximately 90% of Norwegian emission sources. New entrants would have to purchase quotas through the domestic trading system or the Kyoto Mechanisms.

Efficient reporting, control, and sanctions systems to secure compliance are essential. The Norwegian Pollution Control Authority ("SFT") says it is "prepared to take the responsibility for establishing and operating such a system." The importance of reporting and control is evidenced by a recent report prepared by the auditor general’s office showing that in 1998, 252 industrial firms, representing 59% of enterprises granted emissions licenses by the SFT, had exceeded the terms of those licenses. In routine spot checks, 41% of companies visited by SFT inspectors were found to be committing violations. In the public sector, of 86 municipal sewage plants inspected, 49 were found to have exceeded pollution limits.

Norway currently generates almost all its electricity from hydropower. But further hydro development is unpopular because of its effects on the landscape. The importation of electricity generated abroad by coal-fired or nuclear power plants is opposed domestically as even more environmentally unsound. This underscores the need for Norway to pursue cross- border trading and other innovative solutions, including carbon sequestration.

The Netherlands
The Netherlands is planning to meet half of its total reduction commitment (250 million tons of carbon dioxide) under the Kyoto Protocol by domestic actions and half by utilizing the Kyoto Mechanisms. A number of Joint Implementation ("JI") projects have been initiated and verifiers are now undertaking audits. Energy intensive companies have agreed to a covenant concerning energy efficiency benchmarking, while other businesses have concluded voluntary agreements on energy efficiency. These developments, coupled with experience with JI, have made the private sector more receptive to project-based reductions than to cap-and-trade systems. Clearly, however, the Dutch Government realizes that in the longer term the EU, and thus the Netherlands, would have to include emissions trading as instrument to generate reductions in GHG emissions. With that in mind, it is worth noting that:

1. The Netherlands will soon launch a NOx reduction scheme requiring some companies to make payments to a fund, and others to install reductions units and to receive financial compensation from that fund. There is no cap, but a NOx concentration level will be established for covered sectors. The goal is to ensure that cost-effective NOx reductions are taken and that investment proposals reflect real prices.
2. The Ministry of Economic Affairs asked Natsource together with RAND to develop tools for a carbon dioxide emissions trading scheme in the Netherlands; the proposals were presented to the private sector in July 2000. A recently installed Commission on carbon dioxide emissions ceilings will provide advice on the feasibility of an emissions trade scheme.
3. The Social Economic Council (independent advisory council to the Dutch government) advised the government to participate in carbon dioxide emissions trading at EU level rather than at national level, other than for testing, and not to start reductions trading, because of the monitoring aspects and higher costs.
4. An Emission Reduction Unit Procurement Tender ("ERUPT") has been set up to promote investments in carbon dioxide emissions reduction projects by companies, from which the government can buy a share of the credits, called emissions reduction units ("ERUs"). Since these projects will be undertaken pursuant to an umbrella agreement, or Memorandum of Understanding ("MoU"), with Central and East European governments, the tender has aspects of emissions trading.

An ERU has been defined as the reduction or sequestration of GHG emissions by 1,000 kilograms of carbon dioxide or carbon dioxide-equivalent resulting from a project aimed at reducing man-made emissions. The project must be in operation and generate ERUs during the period from 2008 to 2012. The Netherlands will not purchase emission reductions generated before 2008. The governments of Bulgaria, Romania and Slovakia have signed MoU in which they agree to transfer amounts of future JI credits to the Netherlands. More MoUs are being prepared. Guidelines for determining the baseline are available for the estimation of the GHG emission in the period from 2008 to 2012. A baseline study must be validated in advance by one of recognized independent verification organizations, e.g., DNV, KEMA, KPMG, PriceWaterhouseCoopers, or SGS.

After consultations with the European Commission, the Netherlands decided to give ERUPT the format of a European Procurement Tender and to buy only the credits, instead of financing projects. The government expects that this approach will not create a state aid issue. Also, it is unlikely that ERUs will be covered by the WTO (an ERU is not a like a "good" or a "service") and since the government has not said that they will refuse to extend the same benefits to non-CEECs, a conflict with the WTO’s "most favored nation" principle (which prohibits members from discriminating between like goods from different WTO members) is not expected. If the project is successful, a host country may transfer Assigned Amount Units ("AAUs") thereby rendered surplus. However, each host country will need to retain sufficient AAUs to cover the baseline emissions of the projects. This implies that host countries will need a national AAU allocation system in order to participate in ERUPT, so as to ensure their compliance with Kyoto Protocol.

In regards to domestic enforcement rules, the Dutch Government prefers to wait for the developments at international and EU level. But in order to make domestic regimes compatible with cross-border trade and to meet requirements of transparency and accountability for the sovereigns, inclusion of domestic enforcement in national legislation has been advocated. Some Members of the Parliament echoed this claim in the debate on the Dutch preparations of the ratification of the Kyoto Protocol.

The Netherlands ERUPT reflects the Dutch experience with Joint Implementation and the general preference within the private sector for project-based options. Nevertheless, in the rush towards more ERUs, larger projects and less transaction costs, one can envision the gradual evolution toward full emissions trading. Considering the small size of the country, its open economy, plus the Social Economic Advisory Council’s preference for EU-wide emissions trading, one can expect the Netherlands to be one of the first interested Member States to join an EU-wide emissions trading scheme, especially when it starts with carbon dioxide and energy players.

European Union
In March 2000, the European Commission published a climate action plan ("ECCP") and a Green Paper to consult on GHG emissions trading within the EU. Green Paper on ghg emissions trading within the EU, COM(2000)87, http://europa.eu.int/comm/

environment/docum/0087_en.htm>. The European Commission plans to commence emission trading within the Community by 2005 to gain experience before full international emissions trading starts in 2008. Both the ECCP and the Green Paper are intended to prepare the EU for the ratification of the Kyoto Protocol after negotiations in The Hague. Although many in Europe have voiced strong opposition to emissions trading in the past, the Commission hopes its Green Paper will "launch a discussion on GHG emissions trading within the European Union, and on the relationship between emissions trading and other policies and measures to address climate change." According to the Commission, GHG emissions in Europe have been increasing rather than decreasing over the past few years. Without a reinforcement of policy measures, including emissions trading, it is unlikely the EU will be able to reduce GHG emissions 8% below 1990 levels between 2008 and 2012.

This intention is manifest in recent the pronouncements of the Council of Environment Ministers. See Council Conclusions, 22 June 2000, 9420/00, Press 219. The Council recognizes the several emissions trading developments in the EU and stresses the need that emissions trading schemes should be compatible with emissions trading under the Kyoto Protocol and should also meet internal market requirements. The Green Paper builds upon a number of elements that have already been covered in previous Commission Communications. These are:

1. to start a limited emissions trading scheme by 2005 within the Community to enable "learning-by-doing" prior to the Kyoto Protocol’s emissions trading (from 2008);
2. to start with carbon dioxide, the most easily and accurately monitored of the greenhouse gases;
3. the players most suited to start emissions trading are large fixed point sources, which account for almost half of Community carbon dioxide emissions; and,
4. to ensure compatibility between any Community scheme and emissions trading under the Kyoto Protocol.

Envisaged sectors (total amounting for 45.1 % of EU emissions) for GHG trading are: electricity sector (24.9% of EU emissions), iron, steel, refining, chemical, glass, cement, paper/pulp. Other sectors can opt-in by agreeing a certain cap.

In all other respects, the Green Paper leaves options open, although it makes a good case for a strong Community role.

With a view to the relationship with other EU policies, some Member States are of the opinion that emissions trading is incompatible with the Integrated Pollution Prevention Control ("IPPC") EC Directive because the IPPC Directive obliges companies to install best available techniques in each unit and that trading between units is not in line with the underlying principle. Further, they fear that the company that innovates to come up with a new, emissions-reducing technology can’t claim that the resulting surplus allowances are surplus since, under the IPPC, the company should have been using that "best" technology.

In fact, however, the IPPC does not address GHG and climate objectives. The IPPC Directive should be modified, because BAT per unit is definitely not the most cost-effective way to reduce emissions. When the IPPC was debated the EU was not considering that Kyoto Mechanisms would be available for climate protection. This is an aspect the European Commission can put forward in the legislative plan.

Employer organizations in Europe were cautiously positive; they advocate that trading be simple and transparent, and that it be designed to prevent competitive distortion and promote market liquidity.

The Green Paper identifies some of the main challenges confronting countries and stakeholders in designing an effective emission trading program. The debate over national versus international approaches helps clarify those elements in the Kyoto discussion that still have to be addressed. Compatibility amongst schemes and the elements of a sound international emissions trading regime, are issues that also have to be discussed in the framework of the UNFCCC discussions.

Conclusions
We see in Europe a number of public and private emission trading schemes in various stages of development. The Green Paper has fueled an EU-wide debate on the design of an appropriate emissions trading market. From this debate, and from plans for the early phase-in of a variety of these schemes, we can see emissions trading in Europe’s future. The emerging experience augurs for further learning by doing in the establishment of the major building blocks of trading schemes, and for careful examination of the ways in which national and political preferences enhance or diminish the environmental and economic integrity of the systems.

Editor’s Note: Jos Cozijnsen is a self-employed consulting attorney and a legal advisor to various public and private organizations including Environmental Defense. See <http.jos-cozijnsen.nl>. He is undertaking a more detailed and streamlined analysis of the schemes discussed in this article for UNCTAD, with publication anticipated in late 2000.